Valuation Discounts and the Family Business – Plan Now for the New IRS Regulations

THE COUNSELOR

Volume 6 • Issue 11 • November 2016

The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning, business succession planning and charitable planning issues. This month’s issue will discuss the potential impact of proposed IRS regulations on estate planning and business succession planning. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.

In August of this year, the Treasury Department issued proposed regulations that could dramatically affect estate planning and business succession planning. The new regulations restrict or eliminate valuation discounts for family owned businesses. These regulations may go into effect as soon as January of 2017.

What is a Valuation Discount?

The purpose of a business valuation is to estimate the economic value of an owner’s interest in a business. These valuations are used for many purposes, including the gifting of interests in life or upon death. It is a well established principle of valuing a business that non-controlling or non-marketable interests in a closely-held company are not as valuable as a controlling interest in such a company or an interest in a publicly traded company. Therefore, in valuing the interest an appraiser will discount the value to take into account the fact that it is a minority interest or it lacks marketability. In estate planning and business succession planning, this discount in the value can allow an individual to gift larger amounts during their lifetime in order to avoid a greater death tax on the asset. For example, assume you own a 10% interest in a business that is valued at $10 million. If you try to give that interest to your son or daughter without a discount, the gift is worth $1 million and reduces your lifetime gift tax exemption by that amount. However, if you could claim 30% discount because you lack control of the company, that gift is now only $700,000, leaving you an additional $300,000 to gift. The ability to claim a discount is important for several reasons. First, it allows you to give away more of the existing estate. Second, all the growth on those gifts is happening outside of your estate. Finally, it reflects the reality that owning a minority interest or one that cannot be marketed makes the interest less valuable on the open market.

The Proposed Regulations

The IRS has sought for years to eliminate the ability of taxpayers to claim discounts. Their actions have not been successful either in the courts or with Congress. The IRS is now seeking to do by executive action what they could not accomplish in the courtroom or through legislative action. Some of the key components of the proposed regulations are as follows:

The proposed regulations disregard restrictions on liquidation not mandated by law.

The proposed regulations disregard the fact that the transferee is not a full voting owner.

The proposed regulations assume a “put” option allowing the transferee to sell their interest back to the entity at a non-discounted value within six months for cash or equivalents.

The proposed regulations provide that any lapse of a restriction or liquidation right within three years of the transferor’s death is treated as a lapse at death and can be re-included in the decedent’s estate.

While some abuse may have existed in the past, these new regulations assume a false reality. For example, privately held companies do not as a rule offer put rights that can be exercised at will. To do so would introduce significant issues in the business' liquidity.

What Should You Do?

A hearing will be held by the IRS on December 1. The IRS has stated that the regulations will not go into effect sooner than thirty days after they become final. The proposed regulations may go into effect as early as January of 2017. They also may not go into effect at all. The recent election has made this much more likely. However, only transactions that are completed prior to that effective date will be grandfathered under existing law. As with most planning, it is difficult to complete without sufficient time. The wait and see approach may not leave enough time to take some actions. If you hold an interest in a family business, you should consider the impact of these proposed regulations on you and your estate. You should consult with your advisory team about any steps that may allow you to take advantage of the existing law and avoid the negative effect if the proposed regulations become law.

This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.